Paper Losses Aren’t Real. Or Are They? Cutting Losses and Opportunity Cost

Opportunity Cost and Cutting Loss

As an investor, we should always be eager to learn from those around us. But have you ever heard of the saying, “Paper losses aren’t real losses until you sell.”

Paper losses, or unrealised losses, are losses that have not been realised. This is incurred when the price of an asset has fallen after its purchase but has not been sold. Specifically in the context of stocks:

Let’s say, Johnny purchases 100 shares of Carnival Corp, a cruise company, in Jan 2020 at USD 40 per share. Assuming no commissions, this investment is valued at USD 4,000. However, soon after he buys the shares, the price falls over the next few months due to the Covid-19 pandemic. Today the shares trade at USD 28.00 per share. As such, he has incurred a paper loss of USD 1,200.

Should he:

  1. Cut the loss and move on
  2. Hold until it recovers
Opportunity Cost meme

But, wait, why sell? Paper losses aren’t real. Or are they?

Opportunity Cost

Well, sorry to be the bearer of bad news, but, they are. 

The cost of holding paper losses is in opportunity cost.

I think most of us understand better through examples, so let’s go with one.

Let’s say, we were holding 200 shares of Royal Dutch Shell PLC (NYSE: RDS.A) that we bought, unfortunately, in January 2020, just a month before the Covid-19 induced market decline at a price of USD 59 per share.

BAM, Covid-19 strikes and shares of Shell hit a low at around USD 25 per share in March due to border closures and crashing oil prices. But, like the advice goes, just hold right? It’ll go back up, they said.

And it did. Slowly, but surely it did go up.

Today it sits at around USD 39 per share, netting a ~56% return since then.

Ah, but where did the rest of the market go?

Popular S&P 500 ETF, VOO, swung up from the bottoms, hitting new highs to hit a 81.66% return from the March lows. If we look at individual stocks, we have mega cap companies like Amazon, closing off with an almost 100% return from the lows.

Opportunity cost in holding weaker stocks

Smaller stocks like Digital Turbine and Sea Ltd have even returned over 1,600% and 640% respectively to date.

Ultimately, while it didn’t go that badly for RDS.A holders, the index fared better and so did many other individual stocks.

When Should We Cut Loss?

That being said, I’m not saying that we should immediately cut loss whenever something goes wrong.

If we held Amazon instead or an S&P 500 ETF, we shouldn’t be cutting our losses as they fall but instead continue to add since they are more cheaply valued now!

So how do we know when to cut our losses?

The key is in the other opportunities out there, hence, opportunity cost.

Other Opportunities

We should cut loss if we have another company in our watchlist that we are able to grab at a better price.

Naturally, as humans, we are averse to loss. Meaning that we feel the pain of the loss from a bad trade much more than the joy of a winning trade. It is natural and I’ve been through it as well. But when it comes to investing, we must know when to set our feelings aside and make an objective choice.

Re-evaluate the companies that you’re holding and look at the companies that are on your watchlist. 

Looking back at the Shell, it would have been clear to see that with the crashing oil prices, oil companies would be bleeding cash day by day. Heck, at that point in time, it was hard to even say if which oil companies were going to survive the pandemic. 

But if you had companies such as Amazon or Sea Ltd on your watchlist, you might have hypothesized that cloud services, online retail and content delivery networks might become the services that were high in demand as a result of the global lockdowns, with everyone cooped at home and many companies shifting to a work from home arrangement.

And if you had seen this possibility, you would have made a much larger return on your investment.  

Closing Words

Of course, all of this is much easier to say in hindsight. In 2020, I stubbornly held onto some of my REITs, one of which fell 40% from where I bought it, just to wait for it to breakeven to sell it off. Such funds could’ve been put to better use over on the US markets, where my other picks were running on wildly.

But, with every mistake, there is a lesson to be learnt, and I think I’ve learnt this one.

Have you?

Photo by Chase Clark on Unsplash

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3 thoughts on “Paper Losses Aren’t Real. Or Are They? Cutting Losses and Opportunity Cost”

  1. This is lost aversion, or sunk cost bias.

    Use zero-base or blank slate investing psychology.

    Imagine your entire portfolio is liquidated everyday at 5am (that takes care of US positions too).

    In the morning, what will you do with the cash? Buy back at current prices, buy other stocks, or remain in cash?

    If you have done your homework & the thesis/ reasons are still valid, you’ll buy back the same stocks at current prices. Else you’ll move on.

    Another way of looking at it:
    Everyday that you hold on to your positions means you’re buying them back everyday at current prices.

      1. np

        If it’s too stressful to think like this everyday,

        then perform this mental exercise on weekly or even monthly basis.

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